Post on 20-Mar-2020
Tax Consequences of Trust and Estate Settlements and Modifications
David J. Akins
Matthew J. Ahearn Lauren Y. Detzel Brian M. Malec
August 5, 2014
Phil dies survived by his wife, Vivian, his son,
Carlton, and his (adopted) son Will. Phil leaves a
credit shelter trust that provides for discretionary
distributions to Vivian for HEMS during her lifetime
and upon her death, it splits into separate dynasty
trusts for Carlton and Will.
Case Study #1: Credit Shelter Trust
Assume the Credit Trust owns $1 million of securities,
$2 million of rental properties, and a 100% interest in a
family dance studio business (that Carlton now
manages) valued at $2 million. Carlton, being a gifted
businessman and dancer, expects to double the value of
the dance studio over the next 5 years, now that he is in
control and can teach the dance moves that he wants to.
Carlton hates the idea that his efforts to enhance the
business could benefit Will and Will’s descendants in
the future.
Upon Vivian’s death, there is sure to be a fight
between Will and Carlton regarding the division of
the Trust assets, primarily due to the growth or
decline of the business.
However, during Vivian’s lifetime, Will and Carlton
will certainly cooperate because they want an
inheritance from Vivian.
Proposed Solution
Sever and modify the Credit Trust into 2 Trusts.
- Trust 1 will be for the benefit of Vivian for life, with a
remainder to Will in trust.
- Trust 1 will own the rental properties ($2,000,000) and
$500,000 of securities.
- Trust 2 will be for the benefit of Vivian for life, with a
remainder to Carlton in trust.
- Trust 2 will own the interest in the family business ($2
million) and $500,000 of securities.
- The remaining terms of the Trusts will be identical to
the Credit Trust.
Benefits of Severance and Modification
- Each Trust has assets worth $2.5 million
- Only Vivian, Carlton and his descendants will share in the
success or failure of the business. The share for Will and his
descendants is not affected by the performance of the
business.
- Each Trust has assets that, with Vivian’s consent, can be
independently invested without the consent of the other
child.
- Agreement can be made between Vivian, Will and Carlton
that distributions for Vivian will be made equally from Trust
1 and Trust 2.
Options to Accomplish Severance
and Modification
Severance
- F.S. § 736.0417 - Permits severance of a trust after
notice to qualified beneficiaries
Nonjudicial Modification
- F.S. § 736.0412 - Unanimous agreement of trustee and
all qualified beneficiaries
- F.S. § 736.04117 - Decanting (if distributions beyond
HEMS are permitted)
Options to Accomplish Severance and
Modification (cont.)
Judicial Modification
- F.S. § 736.04113 - Modification due to unanticipated
circumstances
- F.S. § 736.04115 - Modification for best interests of
beneficiaries
Funding of Trust 1 and Trust 2
- Pro rata funding permitted
- Non-pro rata funding permitted under the terms of the
trust or, if not, under state law. F.S. § 736.0816(22)
Trustee Liability
- Releases from all interested persons (if nonjudicial) or
court approval (if judicial modification)
- Virtual representation (if minors)
Income Tax Issues
Concern: The exchange of interests by Will and Carlton could
be treated as a sale or exchange under IRC § 1001, which
could result in gain or loss to Will and Carlton to the extent
the amount realized exceeds basis.
Treasury Regulation § 1.1001-1(h)
- The severance of a trust is not an exchange of property
for other property differing materially in either kind or
extent if (1) the severance is permitted by the trust or
state statute, and (2) any non-pro rata funding is
authorized by state law or the trust terms.
- If non-pro rata funding is prohibited, but is used anyway,
then it will be treated as pro rata funding followed by an
exchange of assets between the trusts, which is taxable.
Income Tax Issues (cont.)
Landmark case: Cottage Savings Association v.
Commissioner, 499 U.S. 554 (1991)
- Test: Exchange of interests results in a disposition under
IRC § 1001 only if the interests exchanged are
“materially different in kind or extent.”
- Compare the legal entitlements before and after the
modification.
- This test has been applied by the IRS in numerous PLRs
when analyzing whether a trust modification will be a
taxable disposition by beneficiaries for income tax
purposes.
Gift Tax Issues
Concern: Will and Carlton could be treated as making a gift
to each other by relinquishing their beneficial interest in the
other’s trust.
Gift will be deemed to be made to the extent the modification
shifts value from one beneficiary to the other.
If a bona fide dispute/litigation exists, then a settlement
resulting from the dispute should be treated as a transfer for
full and adequate consideration and, thus, not a gift for gift
tax purposes.
- Ahmanson Foundation v. U.S., 674 F.2d 761 (9th Cir. 1981) –
Intrafamily settlements will not be regarded as a bona fide
compromise unless the claims were legitimate and are satisfied, to
the extent feasible, on an economically fair basis.
GST Tax Issues
Concern: The creation of two new trusts could cause the loss
of GST exemption that was allocated to the Credit Trust upon
Phil’s death.
Preserve GST upon Severance – Treas. Reg. § 26.2642-6 -
Qualified severance
- Pursuant to state law or trust terms;
- Effective under local law;
- Funding must occur within 90 days of severance date;
- Original trust is severed on a fractional basis; and
- Resulting trusts must provide for same succession of
interests of beneficiaries as the original trust.
GST Tax Issues (cont.)
Preserve GST upon Modification – Treas. Reg. § 26.2601-
1(b)(4)(i)(D)
- Modification may not:
(i) shift a beneficial interest in the trust to a lower
generation than those who held interests prior to the
modification.
- shift occurs if there is either an increase in the
amount of a GST transfer or the creation of a new
GST transfer. A modification to administrative
provisions that indirectly increases a GST transfer
will not be treated as a shift of a beneficial interest to
a lower generation.
(ii) extend the time for vesting of any beneficial interest
beyond the period provided for in the original trust.
In 2012, at the age of 89, the Texas oil
tycoon married a woman named Vanna
Nicole who, at 26, was 63 years his
junior!
• Shortly after their marriage, Mone
died and Vanna became the
beneficiary of a $45,000,000 QTIP
Trust established by Mone
• QTIP Trust pays Vanna all income for
life, remainder to Mone’s children
(who are 30 years older than her), if
living
Disagreements ensue about everything
(investments, income distributions,
Trustee commissions, administration
expenses, etc.)
• Trustee engages Dean Mead to
terminate QTIP Trust under Florida
Trust Code using a nonjudicial
modification. 736.0412
• Requires unanimous consent of all
qualified beneficiaries
Scenario 1
• Vanna receives distribution equal to
the value of her life income interest
based on §7520 rate and her current
age (she is now 28); i.e.,
approximately 65%
• Mone’s children receive the
remainder of the QTIP Trust; i.e.,
approximately 35%
Scenario 1
• Vanna has no assets of her own and
has never made any taxable gifts
• Mone used all of his available
exemption (i.e., none was portable to
Vanna)
• What are the gift, estate and income
tax consequences of the termination of
the QTIP Trust?
Scenario 1
• Vanna receives $29,152,350 for her life income
interest
• Vanna makes a Section 2519 gift of the remainder
interest ($15,847,650) in the QTIP Trust to
Mone’s children. PLR 200844010
• Section 2519 gift is a “net gift” of $12,845,464
(because the gift tax is paid from QTIP Trust
remainder – §2207A)
• Gift tax of $3,002,186
Scenario 1
Estate tax consequences:
1. Vanna loses her estate tax exemption to
offset taxes at her death
2. If Vanna dies within 3 years of the
termination, Section 2035(b) brings gift tax
paid back into Vanna’s estate for estate tax
purposes. Estate of Anne Morgens v.
Commissioner
• consider indemnity agreement from
remainder beneficiaries or life
insurance to cover the risk
Scenario 1
Income tax consequences to Vanna:
1. Vanna is treated as having received the value of the life
interest in exchange for the sale of her entire interest in
the Marital Trust. McAllister v. Comm’r.
2. Vanna has zero basis in her interest in the Marital Trust,
therefore, entire amount received is gain. §1001(e);
Treas. Reg. §1.1001-1(f)
3. Treated as amount realized from sale of a capital asset.
McAllister; Rev. Rul. 72-243
4. Capital gain would be long-term because the
termination was more than one year after Mone’s death
5. Vanna’s income tax basis in the assets she receives is
equal to their fair market value. §1012
Scenario 1
• Income tax consequences to QTIP Trust:
1. QTIP Trust does not realize any gain. PLR
200723014
2. Unless appreciated assets are distributed to
Vanna. §1001; §1.661(a)-2(f)
• Income tax consequences to $mith children
1. Tax on any capital gain realized by Marital
Trust paid from remainder interest, reducing
payout to children
2. Children receive carryover basis in assets
received. §643(e)
Scenario 2
How would the gift tax consequences
change if Vanna agrees to receive less
than the §7520 value of her life income
interest?
Scenario 2
Vanna now makes 2 gifts:
1. §2519 gift is same
2. §2511 gift = §7520 value less
amount received
• Annual exclusion available
• No §2207A “net gift”
Scenario 3
How would the gift tax consequences
change if the children agree to receive
less (but not $0) than the §7520 value of
their remainder interest?
Scenario 3
• Same §2519 gift by Vanna
• Children make gifts to Vanna equal to
value of §7520 remainder interest less
amount received. PLR 199908033
Scenario 4
• Sever QTIP Trust first to minimize
tax implications?
• No effect on QTIP Trust that is not
terminated. PLR 200723014 and
199926019
Scenario 5
• Assume that Mone had never used any of his applicable
exclusion amount
• Assume Mone leaves all assets to a Marital Trust for Vanna
with the “hope” that she would disclaim an amount equal
to his exemption, which would pass to his children
• Vanna is the Trustee of the Marital Trust
• For reasons known only to Vanna, she makes the QTIP
Election and does not disclaim any portion of the Marital
Trust
• An estate tax return was filed for Mone and the portability
election was made
• Vanna has Mone’s deceased spouse’s unused exemption
(DSUE) plus her own basic exclusion amount
Scenario 5
• Vanna then marries Mone’s older brother, Even
Richer $mith, who has an even larger estate, but
has used all of his exemption through lifetime gifts
• Even collapses from exhaustion on the
honeymoon and is given days to live
• With Even on his deathbed, Vanna and Mone’s
children agree that she should take steps to use
Mone’s DSUE before Even dies, but she does not
want to (1) terminate the Marital Trust or (2) even
give up the income from the Marital Trust
Scenario 5
• The $45,000,000 Marital Trust is severed into two
Marital Trusts, Trust One with $30,110,762 and
Trust Two with $14,889,238
• Vanna disclaims 1% of the income interest in
Marital Trust Two, which is a §2511 gift of $96,457
• Vanna is treated as having made a §2519 gift of
$5,243,543
• Vanna’s total gifts are $5,340,000 and the DSUE
from Mone offsets the gift tax. §25.2505-2T(b)
• Vanna retains the 99% income interest in Marital
Trust Two for the rest of her life
Scenario 5
• At Vanna’s death, 99% of the value the assets in
Marital Trust Two will be included in her gross
estate. §2036; §20.2036-1(c)
• Vanna’s adjusted taxable gifts (that enter into the
computation of her estate tax) are reduced by the
§2519 gift of the remainder interest in Marital
Trust Two that §2036 includes in her gross estate.
§2001(b)
• Vanna has her own basic exclusion amount plus
the DSUE from Mone (used to make the gifts) to
offset her estate tax. §20.2010-3T(b)(1)(ii)
Scenario 5
• The planning will save approximately
$2,000,000 of estate tax at Vanna’s death
• Vanna’s estate has a right to recover the
estate tax due as a result of §2036 from
Marital Trust Two, unless she specifically
waives the federal right of recovery in her
Will or Revocable Trust §2207B
Case Study #3: Will/Trust Contest
Jay and Gloria are a wealthy married couple.
Jay and Gloria have a daughter together, Chloe.
Jay dies and is survived by Gloria and all children.
Jay wrote his own revocable trust and stated that half of his “adjusted
gross estate” would pass to a marital trust for Gloria and the other half
of his adjusted gross estate would pass in equal shares to all children,
including Manny, outright.
All net income of the marital trust will be distributed to Gloria
annually. The marital trust does not allow for the invasion of principal.
Upon Gloria’s death, the marital trust passes in equal shares to all
children, including Manny.
Years before Jay’s death, he and Gloria separated (but did not
divorce) and entered into a marital settlement agreement.
They later reconciled.
After Jay’s death, his daughter, Claire, claimed Jay’s trust
should be set aside and no part of Jay’s estate should pass to
Gloria due to the marital settlement agreement.
Jay’s estate, and Chloe and Manny, settle Claire’s claims by
buying out Claire’s interest in the marital trust and paying out
her share of the residue of the trust early.
General Tax Considerations
No income tax in settlement of will contest if:
• Settlement payment made pursuant to an enforceable right;
• There is a bona fide dispute; and
• The nature of the transfer is that of a gift or inheritance.
Substantiate these elements in the Recitals of the Settlement
Agreement. Court approval of settlement agreement bolsters
legitimacy of settlement terms.
IRS is not bound, however, by state court ruling, unless it is a
decision of the highest state court.
Sale of Interest in QTIP
- Generally -
• Absence of spendthrift clause allows assignment of interest.
• Value paid for interest must account for time value of money and estate taxes upon death of Gloria.
• The marital trust should also be reformed to remove Claire and her descendants as remainder beneficiaries.
Sale of Interest in QTIP
- Income Tax Considerations -
• Sale of remainder interest by Claire to Chloe and Manny is a taxable event.
• The sale is a capital transaction. The basis is divided between the life tenant (Gloria) and the remainder beneficiary (Claire) based on IRS factors.
• Amount paid should account for estate tax liability upon Gloria’s death, thereby reducing (and possibly eliminating) capital gain on the transaction.
• Basis of Chloe and Manny is not important because it will change upon Gloria’s death.
Sale of Interest in QTIP
- Gift Tax Considerations -
• Transfer for full and adequate consideration after arm’s length
negotiations = no gift.
Sale of Interest in QTIP
- Estate Tax Considerations -
• Purchase must be made by Chloe and Manny from funds
outside marital trust in order to preserve marital deduction.
Sale of Interest in QTIP
- GSTT Considerations -
• None. The sale transaction is between children and has no
impact on a grandchild or remote descendants.
Acceleration of Interest in Residue
- Generally -
• Shifts audit risk (income, gift and estate) to other beneficiaries, and Claire will want indemnification for such potential tax liability.
• Need affirmation that all known assets have been disclosed.
• Need affirmation that all known gifts have been disclosed.
• Claire will accept payment in full discharge of her interests as a remainder beneficiary.
Acceleration of Interest in Residue
- Income Tax Consequences -
• Inheritance not included in gross income.
• Distribution from residue carries out DNI to Claire.
• No gain or loss on distribution. Non-pro rata funding
permitted under Florida law.
Acceleration of Interest in Residue
- Gift Tax Considerations -
• Settlement terms represent full and adequate consideration to
each party after arm’s length negotiations.
Acceleration of Interest in Residue
- Estate Tax Considerations -
• Tax apportionment.
• Deduction of litigation costs as administration expenses.
• Payment of Claire’s legal fees should be part of negotiation
and may be deductible as an administration expense if they are
paid by the Trust. If so, obtain agreement to provide
supporting documentation to IRS.
• Generally, payment of administration expenses must come
from residue to avoid impacting the marital deduction.
Acceleration of Interest in Residue
- GSTT Considerations -
• None. The residuary distribution is to a child and has no effect
on grandchildren or more remote descendants.
Other Issues
- Elective Share -
• Marital Trust counts against elective share at 50%, and 50% of adjusted gross estate passes to Marital Trust. Thus, it appears Gloria may benefit from an elective share election.
• Qualifies for marital deduction.
• Does not carry out DNI.
Other Issues
- Trust Construction -
• Trust does not contain a true residuary clause and construction
action should be included to clarify amount passing to children
constitutes residuary gift and marital trust funded as pre-
residuary, pecuniary gift.
Case Study #4: Decanting
Camille created a Florida irrevocable trust in 2002
that provides for distributions to or for the benefit of
Sarah, and Sarah’s descendants, for health, education,
maintenance and support. In addition, a disinterested
trustee may make distributions for Sarah and Sarah’s
descendants for their best interests.
The Trust provides that 1/3 of the Trust assets shall
be distributed to Sarah once she reaches age 35, 1/2
shall be distributed to Sarah once she reaches age 40,
and all remaining assets shall be distributed to Sarah
once she reaches age 45. If Sarah dies prior to
receiving all of the Trust assets, then the balance is
distributed outright to Sarah’s descendants, per
stirpes.
The Trust assets have grown larger than Camille
anticipated and she does not want Sarah or her
descendants to receive a large distribution of the
Trust assets outright at any age because Camille’s
new advisor has explained to her the benefits of
trusts.
She has concerns that Sarah, Amber and Drew may
lose the motivation to “make something of
themselves” if they receive a lump sum distribution
from the Trust.
State Law Issues
- Phipps v. Palm Beach Trust Co., 196 So. 299 (1940)
- F.S. § 736.04117 – Trustee’s Power to Invade Principal in
Trust
- Trustee must have “absolute power” to invade principal
- e.g., best interests, welfare, comfort, happiness.
HEMS is not an “absolute power”.
- Second trust may include only beneficiaries of the
first trust.
- Second trust may not reduce fixed income, annuity or
unitrust interest.
- Trustee must notify all qualified beneficiaries within
60 days of exercise.
- What if a beneficiary objects?
- What about the Trustee’s liability?
State Law Issues (cont.)
- Assume the Trust does not contain an absolute power to
invade principal, but only permits distributions for HEMS. Can
the Trust still be decanted?
- Florida does not permit decanting based on an ascertainable
standard, but several states do. See Alaska, Arizona,
Delaware, Kentucky, Missouri, Nevada, New Hampshire,
New York, North Carolina, South Carolina, South Dakota
and Tennessee.
- In total, at least 22 states have a decanting statute, each
with their own requirements (Alaska, Arizona, Delaware,
Florida, Illinois, Indiana, Kentucky, Michigan, Missouri,
Nevada, New Hampshire, New York, Nevada, North
Carolina, Ohio, Rhode Island, South Carolina, South
Dakota, Tennessee, Texas, Virginia, and Wyoming).
- Will changes be made to F.S. § 736.04117?
IRS Guidance
- IRS Notice 2011-101 (December 21, 2011) – IRS requested
comments regarding the circumstances under which transfers
by a trustee of all or a portion of the principal of one
irrevocable trust to another irrevocable trust that result in a
change in the beneficial interests in the trust are not subject
to income, gift, estate or GST taxes.
- IRS has yet to issue final guidance and will not issue private
letter rulings in the meantime.
Grantor Trust / Income Tax Issues
- Generally, the grantor of the first trust will remain the
grantor of the second trust. Treas. Reg. § 1.671-2(e)(5)
- Decanting from grantor trust to grantor trust = should not be
an income tax event. Rev. Rul 85-13.
- Decanting from a non-grantor trust to grantor trust = should
not be an income tax event. See Chief Counsel Advice
200923024.
- Decanting from a grantor trust to non-grantor trust =
Possible income tax event. See Madorin v. Commissioner, 84
T.C. 67 (1985); Treas. Reg. 1.1001-2(c), Ex. 5.
Grantor Trust / Income Tax Issues (cont.)
- Decanting from a non-grantor trust to non-grantor trust =
Possible income tax event. See Cottage Savings Assn. v.
U.S., 499 U.S. 554 (1991); PLR 200736002.
- However, one principal argument that the decanting should
not be an income tax event to the beneficiaries is that the
decanting is pursuant to the exercise of a trustee’s power
under state law. It is not an action by the beneficiaries. If
the Trustee is authorized under state law to decant, then the
beneficiaries generally do not have the legal authority to
prevent the decanting and thus, should not be treated as
selling or exchanging their beneficial interest.
Gift and Estate Tax Issues
- Similar to those discussed for the trust modifications in the
earlier case studies.
- As with income tax, a principal argument that no gift should
be deemed to occur as a result of the decanting is that
decanting is the exercise of a trustee’s power pursuant to
state law. It is not a transfer by the beneficiaries. If the
Trustee is authorized under state law to decant, then the
beneficiaries generally do not have the legal authority to
prevent the decanting. Therefore, they should not be treated
as making a gift.
GST Issues
Assume the Trust did not have mandatory distributions once
Sarah reached ages 35, 40 and 45, but instead provided for
assets to remain in trust for Sarah’s lifetime and, upon her
death, pay outright to Sarah’s descendants, per stirpes.
Assume further that the Trust was exempt from GST tax prior
to the decanting. Can the Trust be decanted without losing the
GST exemption?
- The IRS has stated in non-binding private letter rulings that,
at a minimum, a change that would not affect the GST status
of grandfathered GST exempt trusts would similarly not
affect the exempt status of trusts that are exempt as a result
of an allocation of GST exemption. PLR 200839025.
GST Issues (cont.)
Treas. Reg. § 26.2601-1(b)(4)(i)(A) - Safe Harbor Requirements to
Preserve Exempt Status
1. Either the terms of the trust authorize decanting without
the consent of any beneficiary or court, or at the time the
exempt trust became irrevocable, state law authorized
decanting without the consent of any beneficiary or
court; and
2. Terms of the second trust do not extend the time for
vesting of any beneficial interest in the trust in a manner that
may postpone or suspend the vesting or absolute ownership of
an interest, measured from the date the first trust became
irrevocable, extending beyond any life in being at the date the
original trust became irrevocable plus a period of 21 years.
- Postponing or suspending the vesting or absolute
ownership of an interest for a term of years that will not
exceed 90 years is expressly permitted.